Volcker Rule, Once Simple, Now Boggles

If banks think it's too complex, “they have no one to blame but themselves,” Paul Volcker said.Credit
Munshi Ahmed/Bloomberg News

When Paul Volcker called for new rules in 2009 to curb risk-taking by banks, and thus avoid making taxpayers liable in the future for the kind of reckless speculation that caused the financial crisis and resulting bailout, he outlined his proposal in a three-page letter to the president.

Last year, when the Dodd-Frank Wall Street Reform and Consumer Protection Act went to Congress, the Volcker Rule that it contained took up 10 pages.

Last week, when the proposed regulations for the Volcker Rule finally emerged for public comment, the text had swelled to 298 pages and was accompanied by more than 1,300 questions about 400 topics.

Wall Street firms have spent countless millions of dollars trying to water down the original Volcker proposal and have succeeded in inserting numerous exemptions. Now they’re claiming it’s too complex to understand and too costly to adopt.

Having read at least some of the proposed regulations — I made it through about five pages before sinking in a sea of acronyms — I can assure you that the banks are right about that. Even the helpful summary prepared by Sullivan & Cromwell, a law firm that represents big banks and that has associates who no doubt wrote the summary over several all-nighters, runs a dense 41 pages.

In numerous interviews this week with people across the political spectrum, I couldn’t find anyone who actually supports this behemoth — including Mr. Volcker, whose name it bears.

“I don’t like it, but there it is,” Mr. Volcker told me in his first public comments on the sprawling proposal.

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

He says he likes the fact that the proposed regulations, complex as they are, make top management and boards responsible for compliance. “If they think it’s too complicated, they have no one to blame but themselves,” he said of the banks.

Do we need to go back to the drawing board?

“Here’s the key word in the rules: ‘exemption,’ ” former Senator Ted Kaufman, Democrat of Delaware, told me. “Let me tell you, as soon as you see that, it’s pronounced ‘loophole.’ That’s what it means in English.” Mr. Kaufman, now teaching at Duke University School of Law, earlier proposed a tougher version of the Volcker Rule, which was voted down in the Senate. “We’ve been through this before,” he said. “I know these folks, these Wall Street guys. I went to school with them. They’re smart as hell. You give them the smallest little hole, and they’ll run through it.”

“I support the concept of the Volcker Rule,” Representative Peter Welch, Democrat of Vermont, said, “but these rules aren’t going to be effective. We’ve taken something simple and made it complex. The fact that it’s 300 pages shows the banks pushing back and having it both ways.”

And these are Democratic critics of the proposed regulations. An overwhelming number of Republicans oppose them, as they have virtually every aspect of Dodd-Frank. Even Senator Richard Shelby, Republican of Alabama, the ranking member of the Senate Committee on Banking, Housing and Urban affairs, who was the lone Republican to support the tougher Brown-Kaufman legislation, dismisses the latest incarnation.

“This proposal, however, is filled with central questions that Congress should have answered before even drafting Dodd-Frank,” said Jonathan Graffeo, a spokesman for Senator Shelby. “Instead, Congress willfully ignored the ramifications of its actions, just as it did in repealing Glass-Steagall.”

Yet the Volcker Rule, or something like it, could be the most important reform measure to emerge from the financial crisis.

If there was any doubt about that, this week the Securities and Exchange Commission unveiled its latest charges involving mortgage-backed securities. In what may be a new low for conduct by a major Wall Street firm in the walk-up to the financial crisis, Citigroup settled charges (without admitting or denying guilt) that it defrauded investors by creating a package of mortgage-backed securities for which it selected a pool of mortgages likely to default, bet against the security for the bank’s benefit by shorting it and then foisted it off on unwitting investors without disclosing any of this.

According to the S.E.C., one trader characterized this particular security in an all-too-candid e-mail as “possibly the best short EVER!”

Compared with this, Goldman Sachs mortgage traders look like Boy Scouts. In settling its fraud charges for $550 million last year, Goldman was accused by the S.E.C. of being the middleman in a similar deal, allowing the hedge fund manager John Paulson to help choose the mortgages and then bet against them without disclosing this to the other parties.

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Citigroup dispensed with a Paulson figure altogether, grabbing those lucrative roles for itself. The S.E.C. said Citigroup earned fees of $34 million on this travesty and generated net profits of at least $126 million. (In a statement, Citigroup said it was pleased to put the matter behind it and has since “returned to the basics of banking.”) Nonetheless, Citigroup is paying just $285 million to settle the charges, and, needless to say, its chief executive at the time the deal was marketed and closed, Charles Prince, will pay nothing.

I asked an S.E.C. enforcement lawyer if he could assure me that a transaction so brazenly fraudulent — not to mention risky, since a naked short ranks at or near the top of high-risk strategies — would be unambiguously prohibited under the proposed Volcker regulations. “There are some tricky definitions in there,” he said. “Could this be interpreted as hedging? But this was a naked short by the bank, and I believe it would be prohibited.”

I found this less than reassuring, since you can bet that if there was a way to call it hedging, lawyers would find it, and at the very least, years of costly litigation would result.

Last week I stopped by to see the financier Henry Kaufman, a former managing director of Salomon Brothers, a former Lehman Brothers board member and author of “The Road to Financial Reformation” (and no relation to Ted Kaufman, the former senator), who has been arguing for years that the proposed Volcker Rule doesn’t go far enough.

“Nobody listened,” he said. Mr. Kaufman has witnessed, by his count, 15 major financial crises since he and his family fled the Nazis when he was 10 years old.

“Paul Volcker and I are the same age,” 84, he observed. “Paul wanted to take an aspect of risk-taking out of the financial conglomerates. That’s a worthy endeavor. But the history of regulation shows that the private sector pushes back and waters it down. Dodd-Frank didn’t want to address the longer-term consequences of ‘too big to fail.’ The 10 largest banks held 10 percent of the assets in 1990; today they control over 70 percent. This trend accelerated in 2008. The ‘too big to fail’ got even bigger.”

“My view is that we should break up the big financial conglomerates and separate investment banking,” he continued. “Otherwise we’re going to have ongoing government intervention in the credit allocation process. That threatens economic democracy, and the U.S. is the last bastion of economic democracy.”

Financial concentration also worries Congressman Welch, who has called for an antitrust investigation into whether big banks recently colluded to charge debit card fees. “We need a strong financial sector,” he said. “But it should be in service to the real economy, the productive economy. The large banks have become trading platforms. They make the real money on the trading desks. The depositors, the consumers, become a base to fund that trading activity. There should be a separation and there certainly should not be a taxpayer backstop for their losses. Contrast this to the Main Street banks facing severe pressures from the big banks. Their model is more traditional, in service to the productive economy. In Washington the debate is about the needs of the large banks, but there’s no debate about the basic function of these banks. Do we want the financial sector to be in the service of the producing economy, or vice versa? It’s time we call the question.”

Former Senator Kaufman, Congressman Welch and Mr. Kaufman are all part of a chorus calling for a return to the separation of commercial and investment banking once embodied in the Depression-era Glass-Steagall Act, which was repealed in 1999.

“The need for 300 pages of rules just shows you’re trying to define something indefinable,” Mr. Kaufman said. “I think Paul Volcker is great, but let’s step back and ask, why are we doing this? We‘re doing this because we don’t want banks with federal deposit insurance to be involved in risky investments. There’s a simple solution. We didn’t have that problem for over 60 years because we had Glass-Steagall. It worked, we changed it and guess what, we got into trouble. I want to go back to what worked for 60 years. That’s a very conservative position.”

Critics of a return to Glass-Steagall note that Lehman Brothers was an investment bank, and Glass-Steagall would not have prevented its failure. Goldman Sachs and Morgan Stanley were investment banks (and would probably be so again), and yet they were still too big to fail.

Mr. Volcker said that reinstating Glass-Steagall was unrealistic in today’s political climate. “It was a magnificent piece of legislation that didn’t need any regulations,” he said. “Do you think they could rewrite Glass-Steagall today without 300 pages?”

Even if Glass-Steagall isn’t a panacea, it would be a start. It would put a firewall around federally insured institutions, protecting taxpayers and helping contain the crisis as well as potential future ones.

“I don’t know if this Congress will address this,” Ted Kaufman said. “I won’t try to forecast. But I believe from the bottom of my being that we’ll eventually have to restore Glass-Steagall. The only question is, How much agony do we have to go through before we do it? We know the solution, but do we have the will?”

In the meantime, “It scares the hell out of me. We can’t afford to have this happen again.”

A version of this article appears in print on October 22, 2011, on Page B1 of the New York edition with the headline: Volcker Rule, Once Simple, Now Boggles. Order Reprints|Today's Paper|Subscribe